The subject line is a bit misleading, as I'm asking advice for a situation some close friends find themselves in. They've asked for my opinion, and I'd like to be more confident that I've considered all the angles.

Here are the relevant facts that I'm aware of. If you'd like more information, ask the question and I'll try to find an answer to report back.

THE BUYERS:
1) They are both in the early 30s, both working full time, and plan on a traditional retirement trajectory in their early 60s.
2) After taxes, they take home about $100k/year and both feel secure in their jobs.
3) They have one young child now, and another on the way this Fall. This is part of the reason for the move, and the wife will lose some income during maternity leave.
4) Their retirement savings consist mainly of an equity ownership interest in his business valued around $500k.OLD HOME:
5) They've lived in their old home since 2009. They bought it in 2009 for $250k with a 30yr mortgage at 3.25%.
6) They estimate their old home will sell for around $400k.
7) They still owe about $100k on their old home.
8) They mentioned there is some significant work that has to be done at some point soon with the roof and with some sewage line issue.NEW HOME:
9) The new home costs $450k
10) It is about an hour from their old home in their preferred neighborhood / school district.
11) If they don't sell their old home, they will still be able to put down 20% to avoid PMI on a 30yr mortgage at 4.50% (but I got the impression that it would be pretty tight).

THE QUESTION
They're trying to decide if they should keep both properties and rent out their old home, or just sell their old home and put the equity into the new home.

CONSIDERATIONS
They seem to think that because the old house has appreciated in value so much in the last eight years, that they should just hold on to it and watch it double in value again in the next decade. They don't seem too worried about having two mortgages, or about being landlords/Airbnb from an hour away.

I mentioned that if they sell it, they'll avoid tax on the $150k of appreciation as it is their primary residence. After a few years of rentals, they'll be on the hook for a much larger tax bill.

I also asked them, "If you were living in your new house and had $400k extra, would you use it to buy this old house an hour away to use as a rental property?" Both were kinda stumped by that, but they seemed to think, "no, probably not."

My instinct is to tell them to minimize debt and uncertainty and sell the old house (not fire sale, but sell it sooner rather than later). If they really want to own a rental home, it seems to me they should look for another property nearer their new house.

Are there other questions I (or they) should be asking?

Thanks for your thoughts and advice, and sorry in advance if I've omitted something or posted inappropriately; I'm new here.

I would sell. Being a landlord is not a cake walk by any stretch. The laws generally favor the tenant. As a landlord you better make darn sure you cross your T and dot your I. I turned my property over to professional management. For $140 a month it’s worth it to me and I can expense the $140. I have a ace property manager she keeps things 100% on the up and up.

Also, something to consider is they must live in the house at least 2 of the last 5 years to retain the capital gains exemption. Also if they rent it out they will also depreciate the property annually but I believe if they go past the 5 years then they sell they will have to recapture the depreciationwhich means your basis is lower and you will have a larger capital gain=more tax.

I had a older rental home and just recently did a 1031 exchange into a brand new one. If I had sold it outright I had a $90k basis and sold it for $260 that would have been quite a tax bite

Last edited by Sasquatch on Tue May 15, 2018 6:37 pm, edited 1 time in total.

You bring up two more things to think about. They could just have a property manager run the rental, but that cuts even more into the revenue stream; and neither of them has experience as a landlord.

The tax bite after selling the appreciated rental house in the future seems like the overwhelming factor to me. Even if they defer the gains with a 1031 exchange for another (closer) property in the future, it's still quite a bit worse than just selling it tax free now.

One law suit or a tenant who is behind on rent and milks it for 3 month or even a year before you get them out far overshadows the $140/mo IMHO. YMMV

Also, don’t make the assumption that the property value will go up. I was holding properties in the 2009 debacle. Foreclosures galore. Supply increased faster than demand and rents dropped. I had to subsidize a couple of my properties as the rent was lower than the mortgage despite the fact that I had a 60% equity position in my portfolio.

Sell... take advantage of the capital gains exclusion selling their primary home, put more down on the next home so as not too tight in the wallet, and avoid paying for a roof or sewage repair on the old rental home. That's a no brainer to me. If things would be tight buying the new home and keeping the rental, how would they pay for a new roof or sewage repair? That can be tens of thousands of dollars for either one and definitely both if they came due at the same time.

Plus, are they sure they would qualify for the new house keeping the old one as a rental? Without a decent rent history, that simply counts against them and their amount they'd qualify for.

I'd advise my friends I know nothing about real estate rentals. If this is something they want to do they need to figure out how to do it. Unless you really really want to figure it out for them, then take the heat if it does not work out well.
Me, I would admit I do not know how to proceed, but will ask my BH friends if they want.

tbqh, I was just out having beers with them when they shared the news of their new house purchase and their intentions to keep the old one as a rental. I thought immediately that if it was me, I'd sell the old place and be pretty close to knocking out the mortgage on the new place. Life is good with no mortgage!

I wanted to ask BH to try to get the other side of the argument, but I can't see a lot of good reasons to keep the rental. In the absolute best case scenario, they might get solid renters and have property values continue to rise. But there's a lot of ways for that to go wrong, and a new baby on the way; no thanks.

Okay - I'm pretty well convinced; if someone wants to take a turn as devil's advocate I'd like to entertain the counterargument.

I doubt you will find it. There is no good reason to keep the old place as a rental. Things will be tight for them if they keep it and there are major repairs coming up for the to be rental. How would they handle that? They're just banking on future appreciation. That may or may not happen. Plus, they will owe taxes on it if they sell later. They can dodge any taxes now. The pros of selling definitely outweigh the cons here.

I will say my sister (and brother in law) found a way to make it work. But it took work. As near as I can tell doing rental real estate takes work. If they are willing to put in the work it could work out for them.

One thing that has not been mentioned is that when you convert your home to rental the way the taxes for the depreciation work is complex and probably less favorable than if they bought the identical house next door.

If they keep it as a rental then they will be running a business that is worth almost half a million dollars which is almost as much as their current business. At the very least they should have a written business plan and professional tax advice. One issue having a rental property is that you can have a lot of taxes that need to be paid when they eventually sell it. They should have several possible exit plans too.

One other problem is that if they change their mind and decide to sell the house in a few years then they will need to wait until the lease expires. At that point they would need to refurbish the house to get it ready to sell and if the market is not hot then it could take a long time to sell.

With the 20% down payment that they already have and their home equity they could likely pay cash for their new house and then invest their "mortgage payment" each month. Not having a mortgage payment could really help if there are complications with the new baby or if their business has a slow stretch or has a road bump like a big customer that is slow to pay.

1. Tax free gains on the house sale will disappear if it becomes a long term rental. Short term renting it will likely cause it to not be as nice for the resale.

2. The house is an hour away from the new home. It is hard enough to manage the rental if it is in the same town.
3. Another baby on the way. The rental takes time to find a renter, harder to find an ok renter, much harder to find a great renter.
4. Dealing with a terrible renter takes both time and money unless you have an attorney on retainer. Only a property manager has such an attorney.
5. A good proper manager is harder to find than a good renter, a great property manager is harder to find than a great renter.
6. Most landlords who think they have a great property manager are fooling themselves. The entry qualifications for that job is less than that for being an Edward Jones fake financial advisor.
7. If you think your property manager is great... go see what the property looks like after 20 years.
8. Property managers almost never keep up on maintenance, because that takes time and knowledge of how to find the right person to do the job. They want the first person they call to do the job, not the best person. Telling you things are fine takes very little time.
9. The law favors renters.
10. Property managers will always quote 9 when they mess things up, but won't tell you that they are motivated to have one showing and rent it to the first person who wants it.
11. You can offset some regular income with depreciation, but when you sell the house you will pay 25% on recouping depreciation.
12. Even if the house is paid off, in many places you can only make about 0.55 of the rent collected after expenses.
13. Some rental markets are amazing in how fast they appreciate. Those markets can drop like a rock when you least expect it, and you had better be prepared for negative cash flows when that happens.
14. When your house burns down, the bank gets paid first, and you may not get paid the replacement value unless you build a new one.
15. Building a new house an hour away is fun, right?

16. Owning a rental is usually doing to decrease your investments diversification by concentrating too much money in one asset that can depreciate to zero quickly if one persons decides to make that happen, or one flood, or one fire, or one tornado, or one earthquake....
17. Rental houses are expensive and inconvenient to sell.
18. Number 1 is reason enough to sell it rather than rent it.

Don't be an accidental landlord! Owning rental properties is a business. If you want to get into it; do it deliberately, with carefully chosen properties. Speaking after having owned 30 rental properties for 30 years. The only times to contemplate a single, accidental rental, could be that you bought a duplex and you rent out the other half as a start to your RE side business, or are temporarily employed far away (abroad?) and have every intention of re-occupying the same property.

Sell it - two babies, a new house, you don't need the hassle of being a landlord at the same time.

Ding ding ding, we have a winner!

Agree with this advice--at this stage of their professional and family life dealing with a rental property is probably going to more hassle than its worth.

When we moved from-and sold-what had been my husband's small bachelor starter house it was to a larger home literally around the block. For YEARS my mother in law bemoaned and berated us for not keeping it as a rental. There was no mortgage and she and my FIL, as had her parents, had made good money on owning and managing a couple of rental homes for years.

However, they had done that starting long after their children were grown and they were retired. We felt then and still feel that selling was the right thing to do. At the time we, like your friends, had a small child and then another baby on the way. Both of us were working. I can't imagine adding the additional stress of dealing with rental property on top of what is already a crazy time in life. Not to mention selling it gave us some much needed financial breathing space which in turn eased money worries through the expensive child-rearing years.

Ironically, decades later we are now, wait for it, managing a couple of family owned rental properties! However our kids are grown and flown, and we're a year or so away from retirement. So seasons of life come and go. This probably isn't the season for your friends to become landlords.

They are only in their early 30s. With $300k in equity in the current property and another $90k in additional savings, they are only $60k away from a completely paid for home. I'd prioritize that right now. They are a long way from retirement. Having no mortgage payment would allow them to save and build wealth.

They can always buy a rental property down the road if they decide to.

I also asked them, "If you were living in your new house and had $400k extra, would you use it to buy this old house an hour away to use as a rental property?" Both were kinda stumped by that, but they seemed to think, "no, probably not."

Asking them that particular question should enable them to make the correct decision. If it doesn't, there is no point in trying to give them further help with the decision other than by repeating that same question. Everything else just complicates it and distracts from answering that question, and the answer is obvious. If you get further involved in their financial decisions, it might affect your relationship with them.

I also asked them, "If you were living in your new house and had $400k extra, would you use it to buy this old house an hour away to use as a rental property?" Both were kinda stumped by that, but they seemed to think, "no, probably not."

Asking them that particular question should enable them to make the correct decision. If it doesn't, there is no point in trying to give them further help with the decision other than by repeating that same question. Everything else just complicates it and distracts from answering that question, and the answer is obvious. If you get further involved in their financial decisions, it might affect your relationship with them.

Thanks to everyone for the many helpful comments. In particular, thanks CedarWaxWing for that list.
I consider the case closed, but wanted to post an update that relates to Pajamas' post.

I think we're at the point where it's super clear to me (and to you all impartial observers) what they should do, but I don't think they've reached the same conclusion. So it's now a trickier question of inter-personal relationship impact from sticking my nose further in. I'm just going to lay out the facts for them to consider, and that's that. Thank you all again, this has been really helpful!